Dividend stocks lose shine as U.S. bond yields rise

Analysis: Dividend stocks lose shine as U.S. bond yields rise

7:08pm EDT

By Chuck Mikolajczak

NEW YORK (Reuters) – As the S&P 500 stormed to a gain of 16 percent for the first five months of the year, the run was fueled by investors searching for yield.

With central banks driving interest rates lower, slower-growth sectors with big dividends like utilities and telecom were attractive because they offered better returns over government debt along with the possibility of price appreciation.

Those sectors led stocks higher for several months – but that outperformance appears to have come to an end as U.S. Treasury bond yields climbed to 13-month highs this week. The economic outlook in the United States has improved, and rumblings of a pullback in the Federal Reserve’s massive bond-buying program have caused investors to pull away from the big dividend payers.For the year through April 30, the S&P 500 .SPX rose 12 percent, led by an 18.4 percent gain in both utilities .SPLRCU and healthcare .SPXHC, as well as a 17.1 percent climb in consumer staples.

The S&P 500 – with only one trading day left in May – has climbed about 4 percent this month – giving the benchmark index a gain of 16 percent for the year so far, based on Thursday’s close.

Central banks have kept yields low through heavy bond purchases, prompting investors to bid up the prices of corporate and high-yield debt, along with stocks. Still, insecurity about global recovery meant investors looked for “safer” versions of risky assets.

With the S&P 500 showing a dividend yield at 2.4 percent, investors were drawn to sectors with higher yields. The dividend yield on telecoms stands at 4.6 percent, while the utilities sector is at 4 percent and the consumer staples sector .SPLRCS is at 2.7 percent.

The S&P 500 just kept going in May, rising 3.6 percent so far. But utilities have been crushed, falling 9.2 percent, while staples have dipped 0.2 percent and telecoms have stumbled 5.2 percent.

“Because a lot of portfolio managers have been hanging out in the defensive groups – the utilities and the consumer staples – because they were scared of the overall market, they had bid those two sectors, from a historic perspective, to pretty expensive valuations,” said Jeffrey Saut, chief investment strategist at Raymond James Financial in St. Petersburg, Florida.

LOFTY VALUATIONS

A look at the more defensive sectors that hold a large portion of dividend payers shows they have, in fact, become expensive relative to their non-dividend paying peers.

According to Thomson Reuters data, the S&P telecom sector index .SPLRCL – composed of stocks such as AT&T Inc (T.N: Quote, Profile, Research, Stock Buzz) and Verizon Communications (VZ.N: Quote, Profile,Research, Stock Buzz) – sports a forward price-to-earnings ratio for the next 12 months of 18.29, and the forward P/E ratio for the S&P utilities sector index .SPLRCU stands at 15.84.

The forward P/E ratio is a valuation measurement comparing a stock’s price to expectations for its earnings for the next 12 months.

Since the beginning of 2000, the telecoms sector has averaged a forward P/E ratio of 16.70, while the utilities sector has averaged a P/E ratio of 13.46.

By comparison, the forward P/E ratio for economically sensitive sectors such as industrials .SPLRCI stands at 14.59, while technology .SPLRCT is at 13.11 – both below long-term norms.

For the S&P 500 as a whole, the forward P/E ratio is 14.36.

“Investors have realized they have bid these defensive stocks up pretty fully. They are now starting to look ahead to the second half of this year, where we think economic growth is going to be better, and they are looking at a lot of the economically sensitive stocks that are much cheaper than the defensive stocks,” said Phil Orlando, chief equity market strategist at Federated Investors in New York.

Investor interest in dividend funds has remained steady in 2013 even if it’s not as robust as in 2012. However, more investors have started to return to growth-and-value strategies, according to Lipper, a unit of Thomson Reuters. In 2012, dividend funds drew inflows of $14.74 billion, compared with outflows of $23.39 billion from growth-and-value funds, Lipper data showed.

Through May 22, dividend funds recorded inflows of $7.28 billion, compared with inflows of $13.31 billion in growth-and- value funds.

Dividend-oriented exchange-traded funds have dropped off in recent days, with the iShares High Dividend Equity Fund (HDV.P: Quote, Profile, Research, Stock Buzz) falling 1.9 percent in the last 10 days.

The rise in U.S. Treasury bond yields to 13-month highs on Wednesday has also taken some of the shine off the dividend payers as investors start to expect that the Fed could soon scale back its stimulus measures. Higher yields on risk-free government debt make stocks less attractive to more conservative investors.

If the economy does improve in the second half of the year and speculation increases that the Fed may begin to – or actually does – taper its bond-buying plan, the rotation away from dividend payers may accelerate.

Oddly, stocks overall may end up stronger in the longer run.

“If the rotation to cyclical stocks presages more improvement in the economy, the rotation should stick,” said Brad Lipsig, senior portfolio manager at UBS Financial Services Inc in New York. “If the economy softens, you would expect the reverse,” he added.

“But the slow arduous rotation back to stocks from ‘anything but stocks’ should continue for decades.”